• Emerging Market Equity
  • Equities
  • Fixed Income

As China soars, emerging market investors need a rethink

With China set to dominate EM equity indices over the coming decades, investors need to adjust their approach to the asset class, argues Alistair Way.

Chinese bull in front of Chinese markets
zhu difeng / Shutterstock.com

2 minute read

In the early twentieth century, Japanese economists coined a theory of development known as the ‘flying geese paradigm’. The idea was that Japan led the way for neighbouring Asian economies, much as geese fly in a V-shape behind a single leader. The theory gained currency during Japan’s post-war economic miracle, which boosted regional trade and benefited other exporting nations.

However, by the time of its boom years during the late 1980s, Japan was flying so far ahead of other Asian nations that it was reasonable to question whether it should still be considered part of the flock. As Tokyo-based multinationals came to dominate global equity indices, investors sought to manage their Japanese exposure separately.

The same may soon be true of China. Over the last decade, China has soared ahead of Japan to become the world’s second-largest economy. Like Japan in the 20th century, China’s rapid growth and rapacious appetite for resources have transformed the fortunes of emerging markets – and, as with Japan, investors are starting to ponder whether China now requires standalone strategies.

Structural shifts

China has been central to the worldview of EM investors since its entry into the World Trade Organisation in 2001. According to research from the academics Francisco Costa, Jason Garred and João Pessoa, exports from low- and middle-income nations to China rose by a factor of 12 between 1995 and 2010, compared with a twofold increase in their exports to everywhere else.

But despite its transformation into a trading and manufacturing powerhouse, China took a long time to attract foreign capital flows commensurate with its vast size. Restrictions on foreign investment through the Qualified Foreign Institutional Investor (QFII) programme, coupled with inefficient domestic capital markets, proved a deterrent.

Now that is changing. The government is accelerating efforts to liberalise the financial system and bring in more foreign capital, and recent reforms have cleared the way for China’s entry into bond and equity indices.

Chinese large-cap A-shares (shares listed in mainland China) have featured in the MSCI Emerging Markets Index since mid-2018 and their weighting is being ramped up to over three per cent of the index in a two-stage rebalancing process in 2019. Add in H-shares (Chinese shares listed in Hong Kong) and China takes more than 30 per cent of the index.

Capital flows

The rebalancing is set to influence capital flows across emerging markets. As the MSCI index is tracked by more than US$2 trillion of active and passive funds, the rise in China’s weighting is likely to lead to outflows of US$40-55 billion from other emerging markets over the next six months, according to UBS.

A similar reallocation of fixed income capital is likely after China joins major bond indices. The Bloomberg Barclays Global Aggregate Index was the first of its kind to add China, launching a 20-month phasing-in period on April 1, 2019, while JPMorgan Chase & Co. and FTSE are also considering adding China to their fixed income indices. These inclusions could lead to over $200 billion of inflows into Chinese bonds, according to our estimates.

Japan’s experience in the 1980s offers pointers as to how investors are likely to respond to these shifts. At its peak in December 1988, Japan took a 44 per cent share of the MSCI World Index – more than double the country’s proportion of global GDP – as investors sought to tap into the success of multinationals such as Sony.

‘World ex-Japan’ equity portfolios gained prominence as investors sought to avoid concentration risk, which proved shrewd when Japan’s share of the MSCI index fell sharply in the 1990s after the bubble burst. By 1998, Japan’s weighting had fallen to less than 10 per cent of the index.

New indices, active strategies

While China’s growth path looks more sustainable, its rise is set to distort indices in a similar way – over the next few years, China could easily grab 40 per cent of the MSCI Emerging Markets Index. Investors will begin to question the logic of putting an increasingly powerful and affluent China into an investment bucket with much smaller and more volatile markets. Simply put, China is outgrowing its EM peers.

As this trend develops, we expect to see the emergence of new indices that group China with “EM” economies such as Taiwan and Korea – already developed markets in every respect apart from capital-market efficiency – much in the same way that the Europe, Australasia and Far East (EAFE) Index allows investors to cordon off their exposures to the US and Canada. Other, more-developed emerging markets from other regions, such as Poland and Chile, might also be candidates for inclusion in a separate index.

For active investors, China’s dominance will require dedicated strategies that dig into the nuances of its domestic market and take advantage of long-term structural growth trends, from the rise of “new retail” to the spread of mobile payments and other exciting digital technologies.

There is a debate as to whether the flying geese paradigm still holds true for Asian economies. But for investors who can adapt to its shifting relationship with other emerging markets and the rest of the world, China could still be the golden goose of diversified equity portfolios. 

Want more content like this?

Sign up to receive our AIQ thought leadership content.

Thank you for subscribing to AIQ Investment Thinking.

Please enable JavaScript in your browser in order to view this feature.

I acknowledge that I qualify as a professional client or institutional/qualified investor. By submitting these details, I confirm that I would like to receive thought leadership email updates from Aviva Investors, in addition to any other email subscription I may have with Aviva Investors. You can unsubscribe or tailor your email preferences at any time.

For more information, please visit our privacy notice.

Aviva uses your personal data as set out in our Privacy Policy. We use Google’s reCAPTCHA technology to protect our websites from spam and abuse. The Google Privacy Policy and Terms of Service apply to reCAPTCHA.


Related views

Important information


Except where stated as otherwise, the source of all information is Aviva Investors Global Services Limited (AIGSL). Unless stated otherwise any views and opinions are those of Aviva Investors. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Information contained herein has been obtained from sources believed to be reliable, but has not been independently verified by Aviva Investors and is not guaranteed to be accurate. Past performance is not a guide to the future. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested. Nothing in this material, including any references to specific securities, assets classes and financial markets is intended to or should be construed as advice or recommendations of any nature. Some data shown are hypothetical or projected and may not come to pass as stated due to changes in market conditions and are not guarantees of future outcomes. This material is not a recommendation to sell or purchase any investment.

The information contained herein is for general guidance only. It is the responsibility of any person or persons in possession of this information to inform themselves of, and to observe, all applicable laws and regulations of any relevant jurisdiction. The information contained herein does not constitute an offer or solicitation to any person in any jurisdiction in which such offer or solicitation is not authorised or to any person to whom it would be unlawful to make such offer or solicitation.

In Europe, this document is issued by Aviva Investors Luxembourg S.A. Registered Office: 2 rue du Fort Bourbon, 1st Floor, 1249 Luxembourg. Supervised by Commission de Surveillance du Secteur Financier. An Aviva company. In the UK, this document is by Aviva Investors Global Services Limited. Registered in England No. 1151805. Registered Office: 80 Fenchurch Street, London, EC3M 4AE. Authorised and regulated by the Financial Conduct Authority. Firm Reference No. 119178. In Switzerland, this document is issued by Aviva Investors Schweiz GmbH.

In Singapore, this material is being circulated by way of an arrangement with Aviva Investors Asia Pte. Limited (AIAPL) for distribution to institutional investors only. Please note that AIAPL does not provide any independent research or analysis in the substance or preparation of this material. Recipients of this material are to contact AIAPL in respect of any matters arising from, or in connection with, this material. AIAPL, a company incorporated under the laws of Singapore with registration number 200813519W, holds a valid Capital Markets Services Licence to carry out fund management activities issued under the Securities and Futures Act (Singapore Statute Cap. 289) and Asian Exempt Financial Adviser for the purposes of the Financial Advisers Act (Singapore Statute Cap.110). Registered Office: 138 Market Street, #05-01 CapitaGreen, Singapore 048946.

In Australia, this material is being circulated by way of an arrangement with Aviva Investors Pacific Pty Ltd (AIPPL) for distribution to wholesale investors only. Please note that AIPPL does not provide any independent research or analysis in the substance or preparation of this material. Recipients of this material are to contact AIPPL in respect of any matters arising from, or in connection with, this material. AIPPL, a company incorporated under the laws of Australia with Australian Business No. 87 153 200 278 and Australian Company No. 153 200 278, holds an Australian Financial Services License (AFSL 411458) issued by the Australian Securities and Investments Commission. Business address: Level 27, 101 Collins Street, Melbourne, VIC 3000, Australia.

The name “Aviva Investors” as used in this material refers to the global organization of affiliated asset management businesses operating under the Aviva Investors name. Each Aviva investors’ affiliate is a subsidiary of Aviva plc, a publicly- traded multi-national financial services company headquartered in the United Kingdom.

Aviva Investors Canada, Inc. (“AIC”) is located in Toronto and is based within the North American region of the global organization of affiliated asset management businesses operating under the Aviva Investors name. AIC is registered with the Ontario Securities Commission as a commodity trading manager, exempt market dealer, portfolio manager and investment fund manager. AIC is also registered as an exempt market dealer and portfolio manager in each province of Canada and may also be registered as an investment fund manager in certain other applicable provinces.

Aviva Investors Americas LLC is a federally registered investment advisor with the U.S. Securities and Exchange Commission. Aviva Investors Americas is also a commodity trading advisor (“CTA”) registered with the Commodity Futures Trading Commission (“CFTC”) and is a member of the National Futures Association (“NFA”). AIA’s Form ADV Part 2A, which provides background information about the firm and its business practices, is available upon written request to: Compliance Department, 225 West Wacker Drive, Suite 2250, Chicago, IL 60606.